Pros and Cons of FHA Loans
Taking on a home mortgage can be financially daunting, especially for potential buyers struggling to muster the traditional 20 percent down payment.
For many years, homebuyers who needed lower down payments and more lenient qualifications turned to Federal Housing Administration loans, government-backed mortgages that were initiated in 1934. This program continues to support American homebuying today: FHA loans account for 21 percent of all loans.
While the U.S. government does not issue FHA loans or provide financing for them, it does insure the loans. This gives lenders more confidence, who in turn offer loans to borrowers with relatively low credit scores and less-than-stellar credit histories. That means that borrowers who may not qualify for a conventional loan may be approved for an FHA loan. Potential homebuyers work with FHA-approved lenders to initiate the FHA loan process.
But with conventional loans offering low down payments, too, it is important to understand whether an FHA loan is the best option for you. Here are a few of the pros and cons.
Low down payment: Conventional mortgage loans require a 20 percent down payment to avoid paying private mortgage insurance (PMI), a monthly insurance fee tacked on to the monthly loan payment. To avoid paying PMI on a $150,000 loan, for example, a homebuyer would need to provide a $30,000 down payment upon signing for the loan. This type of sum can be prohibitive for many potential homebuyers. Some conventional mortgages come with down payment rates as low as 3 percent, which would mean a $4,500 down payment on a $150,000 loan, but the homeowner will also be required to pay PMI.
FHA loans require only a 3.5 percent down payment, which would mean a down payment of $5,250 on a $150,000 loan. An FHA loan also will allow other people, such as an employer, family member or charitable organization, to contribute to your down payment. Some conventional loan programs may not allow these kinds of outside contributions.
Lower credit scores: A low credit score can be an obstacle when applying for a conventional loan. Applicants with low credit scores may be denied a conventional loan entirely or may only be eligible for loans with higher interest rates.
You don’t need a near-perfect credit score to qualify for an FHA loan because the U.S. government backs the loans. Applicants with credit problems, including bankruptcy in their recent financial history, still could qualify for an FHA loan. To get an FHA loan with a 3.5 percent down payment, you usually will need a credit score of at least 580. You may qualify for a loan with a lower credit score, but your minimum down payment will rise. For example, applicants with credit scores between 500 and 579 will be required to make a 10 percent down payment.
Lower debt-to-income ratio (DTI): Your debt-to-income ratio can be a primary factor in determining whether you are approved for a loan, and FHA loans allow for higher DTIs than conventional loans. DTI is determined by the proportion of your income used to pay off debt every month, and lenders calculate it by dividing your total monthly debt payments by your total monthly gross income.
FHA loans typically allow a DTI up to 43 percent, and some lenders will accept a higher DTI under certain conditions. Conventional mortgages, on the other hand, typically allow a DTI up to 36 percent.
“What the FHA offers that conventional loans do not is significantly more flexibility on the credit side and the debt-to-income ratio,” said Bill Banfield, executive vice president of capital markets for Quicken Loans. “It’s easier to qualify for the program and get into a fixed-rate mortgage that you can afford.”
Housing options: An FHA loan can be applied to several types of housing in addition to single-family homes, including multifamily housing for up to four units, a condominium or a manufactured home that is on a permanent foundation. FHA loan rules require that buyers live in the residence for a year, but you can rent out other units on the property while you live there to generate additional income.
Mortgage insurance premiums (MIP): When conventional loan borrowers do not make a down payment of at least 20 percent of the loan, lenders require them to pay a monthly insurance fee to insure the loan against losses from default. For FHA loans, borrowers are required to pay a monthly mortgage insurance premium (MIP) regardless of how much money they put down. Borrowers also must pay an upfront mortgage insurance fee when they close on the loan that conventional loan terms don’t require.
FHA loans require a 1.75 percent MIP at closing, which would equal $2,625 for a $150,000 loan. Borrowers then typically must pay an additional 0.85 percent of the loan’s value annually in MIP fees over the life of the loan, — higher than the PMI fee, which ranges from 0.15 to 1.95 percent of the loan’s value. Borrowers with conventional loans can stop paying PMI when they meet certain standards, such as paying off 20 percent of the home’s value and making regular, on-time payments. FHA borrowers, on the other hand, typically pay MIP costs for the life of the loan. The exception is those who put down more than 10 percent can drop MIP payments after 11 years.
Housing standards: Not all houses qualify for FHA loans, as the government requires that all homes bought with FHA-backed loans meet minimum standards to protect the health of occupants and are structurally sound and secure. The standards decrease the chances of new homeowners having to deal with significant repairs and renovations and increase the probability that the government can get a good price for the house if it goes into foreclosure.
“The idea is to protect the consumer,” said Blake Music, vice president of direct sales for Ruoff Home Mortgage in Fort Wayne, Ind. “Generally, people who are financing [almost all of a home’s value] don’t have a bunch of money in the bank or a ton of resources. Buying a house that’s safe and will not fall apart is important.”
However, these standards can limit which properties homeowners can purchase with an FHA loan. Inspectors will check off a long list of items when they look at properties that buyers are considering. FHA loan inspections can be tougher than appraisals for conventional loans, Music said. Inspectors may note issues that wouldn’t be a big deal on a conventional inspection, such as paint peeling off a door frame.
These strict standards generally rule out fixer-uppers, as all government-approved homes will need to be safe, structurally sound and free from hazards such as toxic chemicals and inadequate surface drainage. A particularly picky appraiser could make it difficult for a less-than-perfect house to be approved.
Loan limits: Each year, the FHA publishes a chart showing the maximum amount for FHA loans by region. This can be limiting, especially in low-cost areas where FHA limits are 65 percent of “conforming” loan limits. Conforming loans are those that meet guidelines set by Fannie Mae and Freddie Mac.
FHA vs. conventional loans
FHA, conforming — now, here’s one more term we mentioned earlier: conventional loans. Mortgages insured by private companies rather than the government are called conventional mortgages. Some of the most popular conventional loans are those backed by government-sponsored enterprises Freddie Mac and Fannie Mae, private companies chartered by the U.S. government. Here’s how their terms differ.
|FHA vs. conventional loans|
|FHA loan||Conventional loan|
|Minimum down payment required||3.5%||3%|
|Minimum credit score required||FHA minimum is 500, but lenders typically require 580 or higher||620|
|Loan limits (single units)||$294,515 to $679,650 based on location||$453,100 to $679,650 in the contiguous United States|
|Maximum debt-to-income ratio||Typically 43%, higher in select cases||36%|
|Insurance required||Upfront mortgage insurance premium (1.75% of base loan) plus annual premiums||Private mortgage insurance (PMI) required when down payment is less than 20%. No upfront insurance fee.|
How to convert FHA to conventional loans
While getting an FHA loan can be cheaper than a conventional loan, the cost of monthly mortgage insurance fees can become burdensome and borrowers may begin to wonder how they can decrease their monthly payment. FHA monthly mortgage insurance fees are almost always charged until the loan is paid off, so the only way that borrowers can save money is to refinance their loan for better terms.
One option is to convert the FHA loan into a conventional loan. Borrowers first need to make sure that their credit score and credit history qualify them for a conventional loan, as these loans require a higher credit score and cleaner credit history than FHA loans. You’ll also want to see how much equity you have built up in your house. If you owe 80 percent or more of the home’s value, PMI will be included in the payment calculation for your conventional loan. However, once your equity reaches 20 percent of the home’s value, eliminating PMI only requires writing a letter to your loan servicer to request that it be removed.
“Dramatic credit improvements can be a good reason [to refinance],” Music said. “If you pay down the balance and you have [enough] equity, you can [refinance and] get away from FHA mortgage insurance.”
If you think you will qualify, converting to a conventional loan will work like a traditional loan refinance. You can work with lenders to get estimates for interest rates and loan terms before choosing the best option for you.
Be aware that you must pay closing costs and other fees, such as an appraisal fee, when you refinance. In the long term, however, a lower monthly payment could benefit you financially.
Is an FHA loan right for you?
An FHA loan can be an excellent choice for a new homebuyer or someone with a spotty credit history who is ready to buy a house that will be their primary residence. With its low down payment requirement, an FHA loan can be affordable if you don’t have a lot of money upfront.
However, homebuyers also will want to consider whether the cost of monthly FHA mortgage insurance, which typically is higher than PMI, is financially feasible in the long term. On a conventional mortgage, PMI may be dropped after the borrowers build 20 percent equity in the home, but FHA loans can carry the mortgage insurance fee through the life of the loan. Switching to a conventional mortgage once you’ve built up equity is an option, but making the change will require more money in closing fees.
Regardless of which type of loan you choose, all borrowers should think through how much they can afford and how a home loan will impact their monthly budget and financial future. If an FHA loan can help you buy a house and stay within a comfortable budget, it may be the right choice for you.